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Sunday, September 25, 2011

The last time Europe tried fiscal austerity to solve an
international financial crisis (under Heinrich Brüning in Weimar Germany, 1931),
it took 20 years and 50 million deaths to recover. Germany’s current finance
minister, Wolfgang Schäuble, seems to want to go down in history as Brüning’s
21st century reincarnation, although at the moment he is only
advocating austerity for the Eurozone periphery, the PIIGS (Portugal, Ireland,
Italy, Greece and Spain). While it has become clear to the financial markets
and even Christine Lagarde of the IMF and Tim Geithner of the US Treasury, that
not only does fiscal austerity, perhaps counterintuitively, not solve
the debt crises of these states, it actually makes them worse, Schäuble has
hitched his banner to the morality tale that if bloodletting has not worked, then
insufficient blood has been let, and that we must persist with the failed
therapy until the patient has succumbed (with due respects to Paul
Krugman for the metaphor).

What Schäuble and many others fail to realize, is

The Euro crisis, with the single exception of
Greece, was not caused by the fiscal irresponsibility of the Eurozone states
before the world crisis of 2008 (Spain and Ireland were paragons of fiscal
rectitude until then – see particularly Paul de Grauwe on this
point), but by an accumulation of private debt in housing and consumption booms
from which Germany primarily benefited through export surpluses.

Germany is not merely a passive beneficiary of a
lower exchange rate by virtue of belonging to a currency zone of countries with
weaker export performance. It is also a central perpetrator, since its unit
labor costs (wages divided by
productivity) have danced completely out of line with the rest of the Eurozone
in the last decade. And not primarily because its productivity has grown so
much faster, but because wages have been static, while the periphery has experienced
considerable wage and price growth. This disparity between the wage-restraint
core and the inflationary wage-regime periphery is the ultimate cause of the
Eurozone crisis. Neither party can be considered guiltless in this dance, and
they can even be thought of as symbiotic during the boom phase, but ultimately
they are incompatible in a currency union (this was already pointed out by Calomiris in
1998).

The model of world economic growth of the last
20 years is unsustainable. This divided the world into export growth-led
countries with low consumption shares (China, Germany), high consumption, high trade-deficit
countries (USA, Eurozone periphery) and commodity-based, trade surplus (primarily
oil) exporters (Australia, Brazil, OPEC countries, Russia, Norway). The
increasing inequality of income since the 1980s led to a growth-incompatible
lack of underlying effective demand that was compensated by an accelerating and
unsustainable accumulation of (mostly) private debt from the exporters to the
consumers, mediated by a global financial sector playing an elaborate shell
game (see e.g. Ragan 2010,
Stiglitz
et al. 2009).

As appealing as the
imposition of fiscal austerity after the baby has fallen into the well is to
simple-minded economic moralists, and I would be the last person to argue that
states should not spend their revenues wisely, it is collectively
self-defeating in a world financial crisis. This fact, known in the economic
literature as debt-deflation, was already expounded in Irving Fisher’s classic article in
1933 (which incidentally still reads like a résumé of the current crisis).
But austerity is being propounded not only because of simple-minded moralism,
but because key actors are unwilling to abandon taboo aspects of their growth
models:

China will not let the RMB appreciate, thus relieving
inflationary pressure without having to apply the monetary brakes, because it
would challenge its existing export-led growth model that allows rural workers
to migrate to industrial cities but at low levels of domestic demand.

Germany is terrified of letting wage growth
return to its underlying productivity trajectory for fear of losing
international competitiveness, a problem it successfully finessed with wage
stagnation and welfare reform after reunification and the ascension of the
Eastern European members to the EU.

The USA is unwilling or politically unable to reverse the
neoliberal tax and financial system “reforms” and the decline of worker bargaining power that
have only benefited the upper 5% of the population, and invest in needed
infrastructure, education, health-care reform and (energy and environmental) technologies.
Congress is ideologically deadlocked on these issues. The country is wedded to
a high consumption, fossil fuel, financial engineering economic model, with
information technology the only bright spot.

Since there seems little likelihood that the political
system will address these underlying issues anytime soon, current strategies
(quantitative easing, timid stimulus packages, austerity) range from “pushing
on a string” (QE) to downright counterproductive (the Greek bailout coupled
with austerity). Since these issues will reassert themselves one way or
another, they will ultimately force the politicians’ hands and impose some kind
of solution, just like they did in Argentina in 2001. My short-range forecast
is as follows:

Greece will enter a disorderly default within
the next few weeks and will quit or be ejected from the Eurozone. This will be
the best thing that could happen to the Greek economy, and if domestic banks
are closed in a timely manner to prevent a withdrawal of domestic savings
before a forcible restoration of the Drachme, its financial system can come out
of this intact.

To limit contagion to the rest of the Eurozone
banking system and restore relative competitiveness, Germany and the other core
Eurozone countries (the Netherlands, Austria, Finland, Luxemburg, possibly
France and Belgium) will adopt a Core-Euro (C-Euro, instead of the politically uncomfortable DM) currency, which will rapidly
appreciate.

The rest of the Eurozone will devalue to a
Peripheral-Euro (P-Euro).

The resulting tsunami of debt adjustments
between the core, the periphery and Greece will be a challenge to master, but
is a superior solution to the present underfunded EFSF system that would
otherwise have to swallow its own tail, continually bailing out one failing
peripheral country after another until the core creditors themselves would be financially
and politically undermined.

For all the hopes originally attached to the Euro project,
it was doomed from the start and has morphed from a mutually enriching to a
mutually impoverishing form of integration. The question is whether, at a world
and not just a European scale, time remains to reestablish a new, mutually
enriching world economic order before Humpty Dumpty irreversibly shatters. The
last time the world economy shattered for lack of a coordinated response (the
1930s), it certainly took an inordinate amount of blood, toil, tears and sweat to put the pieces back together
again. Are we prepared to go through this again?

Tuesday, September 13, 2011

The fundamental imbalance of the Eurozone has always been the relatively low nominal wages of Germany compared to the periphery (low that is in terms of unit labour costs). Until that imbalance was addressed the Eurozone crisis was always just going to be a matter of kicking the can down the road. Germany leaving the Eurozone cuts the Gordian knot because its currency will immediately shoot through the ceiling while the rump Euro will fall. But that will only exacerbate the problems of its banks, since they will now be sitting on devalued Euro-denominated peripheral sovereign debt (in terms of its new currency, call it the post-Euro DM). So the German government would still not avoid a massive bailout, but at least this will be a one-time affair confined to its own banks and not the bottomless pit of the current rescue fond. But it will be a boon for the remaining countries of the Eurozone, since they will now be free to export their way out of recession and debt and rid of senseless, neo-Brüningesque austerity masochism. So Germany would actually be doing everyone a giant favour by unilaterally leaving the Euro.

Since the only alternative, an internal rebalancing that could have saved the Euro through an expansionary domestic German policy (see my http://sites.google.com/site/savingtheeuro), was never considered and is now moot in face of the current run on peripheral Euro debt (see Paul Krugman in today's NY Times), Germany will exit the zone either voluntarily or soon enough by force of catastrophic circumstances. The present Berlin government may think it can continue fiddling while Rome (and Athens and Madrid and Dublin and even Paris) are burning, or deceive itself that ejecting Greece will save its skin, but the writing is already on the wall.

About Me

I'm a research economist at UNU-MERIT (Maastricht, The Netherlands) and IIASA (Laxenburg, Austria) with a specialization in the economics of innovation, complex dynamics, economic growth and evolutionary economics. By the 2008 world crisis at the latest it became clear that macroeconomics, financial markets and economic policy cannot be entrusted anymore to mainstream economists. Hence this blog.